Jonathan Lipson's Auto Immune: The Detroit Bailout and the Shadow Bankruptcy System

[Jonathan Lipson has been a terrific, episodic, contributor to CoOp on the bankruptcy aspects of the financial crisis and the bailout. He approached me about posting the following very useful set of thoughts about the auto-mess, which I'm happy to now share with you.]

Today’s New York Times reports that President Bush now recognizes that the auto industry’s disease may be worse than the bankruptcy “cure.”

Despite ominous threats that the administration would leave the industry to an “orderly reorganization”, the President is now apparently willing to release about $17 billion in TARP funds, to save the auto industry (at least for a while) from Chapter 11.

According to the Times, the President now believes that:

bankruptcy was not a workable alternative. “Chapter 11 is unlikely to work for the American automakers at this time,” Mr. Bush said, noting that consumers would be unlikely to purchase cars from a bankrupt manufacturer.

While I am ordinarily a cautious supporter of the Chapter 11 reorganization system — and suspect much of today’s trouble could have been averted (or at least minimized) if Bear Stearns had been permitted to go through Chapter 11 — I think this is probably the right move, albeit for the wrong (stated) reasons.

Two Weak Arguments Against Bankruptcy

Two principal arguments are made against auto-maker bankruptcy: (1) as the President suggests, bankruptcy might scare off customers, and (2) it might cost jobs.

There is some truth in both—but probably not much.

First, I am skeptical of claims that people will stop buying cars because a manufacturer is in Chapter 11. After all, virtually every U.S. airlines has been through Chapter 11 at least once. People continued to strap themselves into pressurized metal tubes and fly at 30,000 feet despite bankruptcy's dislocations (no pun). In any event, the only thing of concern to consumers that bankruptcy could likely affect would be warranty commitments. While there’s no guarantee of success, there are ways to deal with this, including acquiring third-party assurance of performance, etc. In any case, if the company reorganized, it would almost certainly “assume” these obligations—and probably work hard to let consumers know that it intended to honor them.

I am sure bankruptcy would scare off some customers. But I suspect that the real problem for consumers (and thus the industry) is, as it has been, the financial services sector, which continues to suck enormous value from the public fisc without, apparently, converting it to productive uses (by, for example, lending to credit-worthy would-be car purchasers).

I know, I know: Detroit makes inferior products. That may be true. I don’t own a car at all, and the one that I once had was a pre-Ford Volvo (it was blown up through no fault of the Swedes). But my sense is that U.S. cars have been getting better and, if the companies survive, this is likely to continue. In event, it doesn’t really matter. If, as was reported today, Toyota can’t sell cars in the U.S., no one can.

The second argument—about lost jobs—is doubtless true, but likely exaggerated. The Center for Automotive Research has estimated that millions of jobs would be lost if the car companies went under. But Chapter 11 probably wouldn’t eliminate all of these jobs. Rather, at least in an “orderly” reorganization (more about this below), the companies would restructure and likely emerge in some newer, smaller (perhaps better) form.

Don’t get me wrong: Even a successful Chapter 11 would cut plenty of jobs and benefits. The Bankruptcy Code specifically gives debtors the power to reject or modify (breach) collective bargaining and benefits agreements. This is a gross simplification, but if this power were used (and there are plenty of impediments), it could convert workers’ rights into unsecured claims against the company (very small dollars) or shift these obligations to the Pension Benefit Guarantee Corporation, which may not be quite so generous as GM. In any case, bankruptcy could be used to dilute the companies’ obligations under their ostensibly outsized union obligations.

But it wouldn’t be pretty. Indeed, the prospect of a nasty fight over these contracts may be one reason the administration relented: They may understand that no auto industry bankruptcy could be “orderly” for this reason alone (and there are others discussed below).

Moreover, many of these jobs and benefits already have been lost or reduced. Indeed, if you look at what has happened (and is continuing to happen), a slow-motion, herky-jerky form of “workout” is already taking place. The UAW and (to some extent) management have already made significant concessions. The union has taken over some legacy health care costs and cut some of the fat from its workplace rules.

According to the Times, today’s proposal would accelerate this:

The loan deal also requires the companies to quickly reduce their debt obligations by two-thirds, mostly through debt-for-equity swaps, and to reach an agreement with the United Auto Workers union to cut wages and benefits so they are competitive with those of employees of foreign-based automakers working in the United States.

As I’ve noted in prior posts here, these are the sorts of moves that should accompany any restructuring, within or without bankruptcy. The parties, not the taxpaying public, should share these losses if at all possible. While I would prefer no bailout, these are the sorts of conditions I would have hoped attached to all TARP money.

If the stated reasons for avoiding bankruptcy are not persuasive, why do I nevertheless think it’s the right move here?

Chiefly because bankruptcy reorganization today is not what it once was, and those changes may matter in this context. The Administration’s (currently abandoned) hopes for an “orderly” reorganization are likely to be unrealistic—and not just because of fights over wages and benefits.

The Shadow Bankruptcy System

The real problem may be what we can think of as the rise of the "shadow bankruptcy system"®. We have all (sadly) become familiar with the notion of a “shadow banking system”—the unregulated mass of hedge funds, private equity funds and investment banks that got us into this mess in the first place.

Bankruptcy has not been immune from this phenomenon, although we don’t talk about it much. But the same sorts of players that got us here—hedge funds and private equity funds, in particular—also play the market for claims against distressed firms. And this can make the shadow banking system look like sunshine itself.

As I argue in this draft paper (written last summer), Chapter 11 increasingly looks like an unregulated securities market. This is due to the explosive growth in trading claims against distressed firms.

Historically, when a company went into Chapter 11, creditors (and perhaps irrationally exuberant shareholders) would wait—often years—to get paid some fractional amount of their claims or interests. Beginning in the 1990s, however, smart people with money recognized that they could purchase these claims and shares—often at bargain prices.

The original creditors would want to sell because they would get cash up front, even if significantly discounted. The purchasers would want to buy because, if successful, they might be able to acquire enough claims to reach what is now known as the “fulcrum point”—sufficient investment across the capital structure to influence the case and (more important) to make money no matter the outcome. Think of it as a sort of applied version of the Capital Asset Pricing Model.

Like secondary markets for securities generally, there is much to be said for the development of claims trading. At least in theory, it probably does—or at least could—link capital and assets in a more efficient way than a bankruptcy court.

But, like all unregulated markets, the potential for abuse is enormous. Claims traders may have very different interests than original company creditors. Odd as it may sound, they may, for example, want to see the reorganization fail, not succeed.

Why? Two reasons.

First, these same folks may also want to buy the debtor’s assets. This is especially likely if they have purchased claims secured by those assets (in which case they may be able to “credit bid” their claims). Assets are likely to be cheaper in a liquidation than if sold (or retained) as a going concern. Lynn LoPucki and Joseph Doherty have recently made the case that these sorts of “fire sales” are occurring with disturbing frequency even in Chapter 11 reorganizations. As I argue in the linked draft, if they are right, it may be in part because the reorganization process has been distorted by the shadow bankruptcy system.

Second, and more ominously, there is (as also discussed in the linked draft) some evidence that these sorts of folks may also hold credit default swaps that pay off only if the reorganization is worse than expected. That is, they may have purchased credit protection that is triggered when a company sells certain assets, or pays less than a defined amount on its debt, and so on. Either way, the moral hazard is obvious.

Thus, the real problem here, as with any unregulated securities market, is opacity that permits (and perhaps encourages) these sorts of perverse incentives. Given the velocity and secrecy of claims trading, we do not know who holds what claims against what debtors, in what amounts, and what their real goals are. We thus lack the capacity to know who can really control cases.

For lots of bankruptcies, this may not matter much. But the auto industry is different. I admit that it is unlikely that any one investor could acquire enough GM debt or shares to control a bankruptcy. The problem is that we just don’t know who is out there, or what they are doing in this context. To paraphrase the great epistemologist, Donald Rumsfeld: In reorganization we increasingly don’t know what we don’t know. That lacuna is likely to matter here.

Moreover, while it may be true that Detroit’s products are not great, U.S. manufacturers cannot be credibly blamed for their predicament. The auto industry (as such, and not owners such as Cerberus) had no obvious and direct role in the events leading to the Great Credit Seizure of 2008.®

The industry—and its thousands of direct and indirect employees and suppliers—are nevertheless vulnerable victims of it. They are to credit system failure what an immune-suppressed person might be to, say, avian flu. While they may not have caused the infection, their condition may frustrate their ability to survive it.

Thus, the “auto immune system” (sorry) is literally compromised. But the traditional hospital for sick companies—Chapter 11—may be infected with the same sorts of diseases that hurt these companies (and the rest of the economy) in the first place. Much as it pains me to admit it, I think the administration may have it right, here—for reasons that it doesn’t even know.

Posted by hoffman at 03:03 PM | Comments (4) | TrackBack

Sloppy, Inconsistent Federal Corporate Governance

Lawmaking is a sloppy spectacle, perhaps especially amid crisis like now when Congress offers conditional financial assistance to save private banks and car makers. It is possible that once the entire process is complete a coherent law will result. So far, Congressional actions are not encouraging—and may worry even those scholars and policy analysts who may generally prefer moving from state-by-state corporate law production to a federal corporate law regime.

First, there appears to be no principled basis to distinguish the federal corporate governance conditions proposed to be imposed on the auto industry under the House bill (HR 7231) voted up yesterday and the comparatively loose conditions imposed on the financial industry under the economic stabilization act passed two months ago.

Principal examples are limitations on dividends (to be imposed on car makers but not on banks), limitations on corporate jets (car makers can’t own or lease them but banks can) and limitations on executive compensation (stringent for Detroit, weak for financiers).

Second, the draft House bill has some internal inconsistencies and provisions that are redundant because they already exist in federal law. These concern standards for executive compensation and corporate governance to be specified by a Presidential designee. 12(b)(2).

One pair of provisions seems hard to reconcile. One imposes a total ban on incentive pay to a company’s 25 highest-paid employees. 12(b)(3)(D). Another limits incentive pay to the 5 highest-paid employees so as to avoid promoting taking “unnecessary and excessive risks that threaten the [company’s] value.” 12(b)(3)(A). So the former bans top-dog payments entirely while the latter allows for conditional payments, to very top dogs, so long as they do not promote unnecessary or excessive risks.

Other bill provisions suggest an intention to privilege the conditional payment provision. It says that a company can recover any incentive compensation payments that were made if it turns out they were made based on materially inaccurate financial reporting. 12(b)(3)(B). That remains a strange provision, however, because such a recovery provision already exists in federal law, courtesy of the Sarbanes-Oxley Act of 2002, the hastily passed law that responded to the corporate accounting fraud scandals of the early 2000s.

The bill does another very bold thing not achieved even in the revolutionary atmosphere that resulted in Sarbanes-Oxley incrementally enacting federal corporate law usually left to states. The bill would flat out ban compensation plans that encourage accounting manipulation. 12(b)(3)(E). This is a problem for all companies and all compensation plans. It is not obvious why this rule must apply to auto makers borrowing from the government and not to financial institutions or any other company for that matter.

As to jets, finally, 12(b)(4) says car makers with outstanding government support “may not own or lease any private passenger aircraft, or have any interest in such aircraft” and existing interests don’t violate this provisions so long as the company “demonstrates to the satisfaction of the President’s designee that all reasonable steps are being taken to sell or divest such aircraft or interest.” Nothing like that applied to financial institutions and there does not seem to be any principled basis for it.

It seems instead to reflect the circus that one Member of Congress created at hearings rebuking the car makers’ CEOs for coming to Washington in expensive jets to ask for federal financial assistance. It is symptomatic. Explanations for the sloppy and inconsistent federal corporate governance regime emerging in these legislative exercises appear to reside in expediency, politics and lobbying—not rational judgment concerning what is optimal corporate governance, good economics or good law.

Posted by Lawrence_Cunningham at 11:26 AM | Comments (0) | TrackBack

Rational Actors and the Economic Crisis

I missed this when it originally happened, but you should read Richard Posner's take on the financial crisis, as delivered to Columbia law students.

Posner devoted the bulk of his presentation to outlining the myriad motivations behind the excessive risks. What disturbs him most, he said, is that all of the risk-takers – from CEOs to the day traders to home buyers – were behaving rationally, which free-marketers such as Posner generally believe should act as a bulwark to protect against such catastrophes.

The bankers, for example, were rational in betting on mortgage-backed securities and other housing-related investments, even long after they recognized that their entire industry was, in fact, standing deeply inside an enormous, overstretched bubble. “Even if you know you’re in a bubble, it’s extremely difficult to get out,” said Posner. Pulling up stakes before the bubble explodes means telling investors to expect smaller short-terms rewards. “I think that is a very hard sell,” he said.

Besides, Posner added, when investors want to balance their portfolios, they will do it themselves with, say, bonds or treasuries. The purpose of the high-risk funds is to take the high risks necessary to generate the outsized profits.

Posner also cited the win-win structure of most top executives’ contracts: If their high-risk decisions result in big gains they receive huge bonuses, and if the gambles fail they result in huge severance packages. He noted the $161.5 million awarded last year to outgoing Merrill Lynch chief Stanley O’Neil. “Very, very generous compensation incentivizes executives to maximize their short-term profits,” he added.

Boards of directors, Posner lamented, are hardly “reliable agents of shareholders.” With compensation in the high six-figures for positions that require them to attend only a few meetings per year, board members would need to act against their own self-interest to contest a CEO’s plus-size salary – which wouldn’t exactly be rational.

“This is rational behavior. This is troublesome for economists,” Posner said. “You can have rationality and you can have competition, and you can still have disasters.”

Though he said he wanted to end the presentation on a high note, Posner seemed to have trouble finding one.

There is much here to agree with, particular Judge Posner's skepticism about the efficacy of regulation. But I'm not as convinced (as he is) that this story is best explained as a failure of perfectly maximizing actors. Indeed, as the story describes his position, it sounds like many of the agents were not maximizing at all. Why, for instance, could bankers not convince (purported) rational investors that we were in a bubble? The best reason, which Posner hints at, is overoptimism bias. Why aren't executives' contracts structured for long-term return instead of short-term profit taking? Wouldn't rational boards and rational executives prefer a smooth future income stream? I've got to think that a rich account of compensation behavior would take into account both the tournament effect and risk aversion. And why isn't there a better market for board members? Could it be some kind of bias against out-groups?

Posted by hoffman at 02:06 PM | Comments (3) | TrackBack

Teaching the Financial Crisis in Business Associations

The legal blogosphere (with good reason) has been so abuzz (ablog?) with the financial crisis that I felt adding my two cents might be overkill (I’d add links to all the good blog posts, but figure it’s just easier for you to scroll down and read them).
I will say, though, that teaching Business Associations this fall has been fascinating yet challenging because I’ve really (really, really!) wanted to spend time talking about that lumbering elephant swinging its trunk and trying to get into my classroom. At the same time, of course, we have to go through the basic doctrines - choice of entity, piercing the veil, shareholder primacy, etc., etc.
I have been striking a balance by having a few limited discussions of the root causes of the crisis, and to use it as a way to discuss matters already raised, including conflicts of interest, excessive risk, and principal-agent problems. I am also using this as a vehicle to explain “short sales," and giving an introduction to some of the broad outlines of securities regulation that I examine later in the course. My students also analyzed the initial text of the Bailout Bail (the rather alarming short version), and they write short “response papers” to stories in the W$J.
While you don't want to ignore that rather large creature with wrinkly gray skin, I also don't want to do much more. I remember spending 99% of my legal ethics class (w/A. Dershowitz) discussing the ethics of the then-pending Clinton impeachment. It was a stretch, and only manageable because of who the professor was. How do you incorporate current events into the classroom?

Posted by Miriam_Cherry at 03:36 AM | Comments (1) | TrackBack

Let the Punishment Fit the Harm

As a recent BBC documentary has suggested, the banking crisis involved incompetence, fraud, or some toxic mix of both. The criminal law is often concerned with the distinction between evil, mental illness, and stupidity, and perhaps those mens rea issues should inform investigations into entities like ratings agencies or investment banks. Yet given the degeneration of corporate ethics, scrutiny of these managers' states of mind might prove as fruitless as it would be endless. The main threat these people now pose is their ongoing undue influence on our political system--for their nonstop cultivation of Congress and the White House has turned out to be the wisest investment they ever made. And the lobbying continues, as intensively as ever.

Nobelist Joseph Stiglitz recognizes the extraordinary injustice of recent events:

Too many bankers and other lenders have been focused on trying to beat the system by getting around accounting and banking regulations (through what is called accounting and regulatory arbitrage). Indeed, with bonuses based on short-term profits, they had every incentive to gamble and connive. And now that there’s a bust, no one is being asked to pay back the hefty bonuses earned during the boom.* On the contrary, even as they are dismissed, those who helped send their firms and the American economy into a tailspin are rewarded with generous severance packages. They are enriched regardless of what happens to investors, homeowners, and others who lost so much. Unless we reform incentives, the financial sector will only try to circumvent whatever new regulations are put in place.

Having made so many others financially insecure, those who grabbed while the getting was good are relatively even better positioned to fund campaigns and the 527s now scurrying to stop a Democratic supermajority. One wonders, for instance, why the British plan to prop up their banking sector demanded a 12% rate of return for taxpayers and influence over the use of funds while the US plan only generally demands 5% and offers government little more than moral suasion over how the funds are allocated.

(And that moral suasion isn't working too well--Morgan Stanley appears to be set to give out even more bonuses, and it's by no means clear that a big proportion of the US bailout won't be squandered on massive executive compensation, dividends, and mergers.)

One hope here is that as fraud cases accumulate, some sort of settlement will be reached to help stop the pattern of socialized risk and privatized gain. Just as Fannie and Freddie were forbidden to lobby, Wall Streeters' ongoing efforts to skew the bailout in their favor should lead to scrutiny of their political spending. Given the crisis, outright bans on their political spending might be considered, First Amendment considerations notwithstanding--as Judge Posner never fails to remind us, the constitution is not a suicide pact. Corrective justice also suggests we spend less time waving the threat of prison at those investigated, and more on crafting settlements that recover for the public purse some portion of the billions of dollars of bonuses this fraudulent paper generated. If we fail to do that, Madeleine Bunting's indictment of the system will only ring more true:

Those who will pay the heaviest price for the foolhardiness of deregulated financial capitalism are among those who are least responsible, as Brazil's President Lula angrily pointed out last week. The shockwaves of the west's banking crisis will shipwreck more vulnerable countries. In developing countries, people don't have the resources - welfare provision, savings, insurance - to tide them over a crisis. Instead, they go hungry, homeless - and they die.

Those who made fortunes creating this mess deserve to pay for cleaning it up. And before such an idea is dismissed as hopelessly complex to implement, perhaps we should consider re-assigning the IRS agents now charged with scrutinizing, Inspector Javert style, some EITC recipients' hundreds of dollars of fraud, to the investigation of the real basis of Wall Street's hundreds of millions of dollars of wealth.

*After Stiglitz's piece went to press, NYAG Andrew Cuomo started investigating AIG, in an action that could be a model here.

Posted by Frank_Pasquale at 09:58 PM | Comments (8) | TrackBack

Three Blind Mice

I saw Alan Greenspan's opening statement today at the House Oversight Committee, and I was happy to see a pretty chastened policymaker on display. But as Chairman Waxman suggested, one has to acknowledge that in at least some respects, the three bureaucrats testifying today (Greenspan, Cox, and Snow) were willfully blind to some obvious dangers in the credit markets:

Over and over again, ideology trumped governance. Our regulators became enablers rather than enforcers. Their trust in the wisdom of the markets was infinite. The mantra became: government regulation is wrong and the market is infallible.

Our focus today is financial regulation. But this deregulatory philosophy spread across government. It explains why lead got into our children's toys and why evacuees from Hurricane Katrina were housed in trailers filled with formaldehyde. . . .

The Federal Reserve had the authority to stop the irresponsible lending practices that fueled the subprime mortgage market. But its long-time Chairman, Alan Greenspan, rejected pleas that he intervene. The SEC had the authority to insist on tighter standards for credit rating agencies. But it did nothing despite urgings from Congress. The Treasury Department could have led the charge for responsible oversight of financial derivatives. Instead, it joined the opposition.

Jacob Weisberg rounds up a list of these and other suspects--some of whom still today insist that the answer is to give the wealthy more tax cuts. Could Saramago's Blindness be a metaphor for ideology resilient against all facts?

Fortunately, Michael Greenberger is asking the hard questions--and Wall Street historian Steve Fraser is demanding that we start insisting that our investment be directed to productive projects, not castles in the air that appear to generate little more than fee income for rich bankers and enormous risk for the rest of us.

Posted by Frank_Pasquale at 01:43 PM | Comments (0) | TrackBack

Federalized Deregulatory Corporate Law

Since the country’s founding, states have fashioned most of the regulatory landscape for the incorporation and supervision of corporations in the United States. Many laud the resulting competition among states as they pioneered innovation in laboratories of experimentation to determine the optimal structure of corporate law.

In recent years, that competition abated considerably, Delaware having won, with some newfound competition for it from Washington taking the place of erstwhile state competitors. To many, including Roberta Romano, that state system of corporate regulation appeals and a deep commitment to state production sought, yielding a race to the top; to others, say Lucian Bebchuk, that system fails miserably, being a race to the bottom, and can only be corrected by preempting state corporation law and vesting corporate authorization and supervision in federal law.

The logic of the Treasury Department’s blueprint for changes in US financial regulation offers up yet another alternative that may likely be unappealing to both sides of that debate. State corporate law could be preempted in pretty much the same way that the blueprint imagines preempting state insurance law.

An optional federal corporation charter could begin the transformation, perhaps followed in future years by mandatory federal incorporation for corporations of systemic significance. This program could likewise include forms of business organization, other than the corporate form, that states from time to time have authorized, such as limited liability companies or limited liability partnerships.

Power to establish legal regulatory principles applicable to corporations would be vested in Congress. It would then delegate those functions to new federal agencies that Treasury’s blueprint proposes, which it calls the business conduct regulator and the corporate finance regulator. They bear a resemblance to today’s Securities and Exchange Commission, except with a commitment to further delegation of authority to self-regulatory organizations along lines that the Commodity Futures Trading Commission is famous for.

So these federal agencies would delegate many functions to self-regulatory organizations (SROs), principally the stock exchanges, including the New York Stock Exchange the NASDAQ as well as foreign exchanges, like the London Stock Exchange. Those organizations would assume responsibility for establishing applicable laws and regulations and resolving resulting disputes, chiefly through forums such as binding arbitration.

Delaware and the other US states would be out of this business, at least for enterprises of any significant size or systemic significance. Competing global stock exchanges would supersede them. A race to the bottom or top would ensue on a world scale. The result would be a federalization of corporate law but probably on highly deregulatory terms.

Posted by Lawrence_Cunningham at 10:14 AM | Comments (0) | TrackBack

Are Pitchforks Next?

This is a story from last week that should have gotten more attention. Richard Fuld, CEO of Lehman, was knocked out by one of his bankers as he worked out in the firm's in-house gym in London.

"He was on a treadmill with a heart monitor on. Someone was in the corner, pumping iron and he walked over and he knocked him out cold."

Very satisfying! Especially since Fuld had been puffing up Lehman's chances over the preceding several weeks. (Whether that sales talk should be actionable in light of the psychology of Lehman's fall - i.e., whether you should be able to puff yourself out of a bank run - is an interesting legal question.)

It would be useful for policymakers to think about ways to channel this kind of anger productively. For violations of the duty of loyalty, we're already talking about leaving corporate executives naked, homeless, and without wheels. But what can we do about "mere" incompetence that imposes severe social costs? As I've been telling my corporate law class these last few weeks, current doctrine provides very weak to nonexistent remedies for negligence, no matter how widely its effects are felt. This doctrine is based on an empirical intuition about the relationship between law, risk-taking and entrepreneurship. That is, the law assumes that business risk-taking requires a special kind of legal immunity, and is particular liable to be badly judged in hindsight. I suspect that both of these assumptions are wrong, and hope that the present crisis presents a useful forum to think about our current corporate-negligence regime more critically.

Otherwise, I fear the fire next time.

(H/T: Reader/Student S.D.; Image Source: Wikicommons, the Astor Place Riot of 1849)

Posted by hoffman at 10:55 AM | Comments (1) | TrackBack

The Manicures Don't Matter; the Campaign Contributions Do

There are going to be more shocking revelations of Wall Street decadence in coming weeks; AIG's managers' manicures are just the beginning. While not yet demagogic, this focus obscures the real story of our ongoing economic collapse: the self-reinforcing cycle of money and favors that led to disastrous policy choices not to regulate the finance industry more. Ellen Miller of the Sunlight Foundation has summarized the process: "the finance, insurance and real estate (FIRE) industries that collectively are at the center of the current crisis are the single largest sector–by far–of all the major economic and interest groupings that give campaign contributions to federal politicians." Here is Larry Makinson's visualization (if you like Edward Tufte, you'll love this):

In media prone to parrot compartmentalized "experts," these relationships between economics and politics are rarely in the foreground. It was refreshing to hear Danny Schechter make the connection on the Tom Ashbrook show when an apologist for laissez-faire started talking about how important a government policy of increasing homeownership was to the current crisis. Schechter simply asked: who lobbied for that policy? or for no regulation of derivatives? or for the SEC's oxymoronic "self-regulation?"

Anyone with a nodding acquaintance with Charles Lindblom's Politics and Markets (or Owen Fiss's Why the State) understands the problem of circularity--the intimate interconnection of political and economic elites. Real campaign finance reform would help break down those ties. As it stands, Wall Street titans can use the tens of millions of dollars they earned in the "boom" to influence policy during the bust--and can count on the Supreme Court to slap down any "millionaire's amendments" that could retard that process.

As we reap the whirlwind of years of conspicuous consumption and positional competition, we may want to consult the thought of Thorstein Veblen, who never cordoned off economic thought from the types of political and psychological analyses necessary to understand flows of money and power:

[A] prime theme (or principle) of Veblen’s is that of institutional holism, which is advanced in various ways in all his works, but . . . especially in The Theory of the Leisure Class (1899). Central to holism is the need to study the interplay of social, political, and psychological factors in the determination of economic processes. Economics is part of an open system, with determination including values, beliefs, individuals, institutions, social behaviours and human-centred aspects of the provisioning process. Every aspect of economics, in this view, needs to be situated within a broad framework of reference in order to comprehend adequately the nature of the processes in motion and to recognise the element of novelty and creativity that are prime factors in change (along with blind drift).

At least we can now recognize where the "blind drift" of a politics mastered by market forces has led us.

Posted by Frank_Pasquale at 06:00 PM | Comments (2) | TrackBack

Deregulatory Fundamentalism at OCC,OTS, and SCOTUS

Jonathan Lipson's superb post on the credit crisis reminded me of my colleague Linda Fisher's work to stop predatory lending in New Jersey. She and allies worked hard to get the state to investigate and end abusive practices. . . only to run into President Bush's Office of the Comptroller of Currency and Office of Thrift Supervision. Both entites feverishly preempted state efforts to stop the worst practices of subprime lenders. The preemption program came to fruition in early 2004. Supreme Court, Inc. then went on to validate more radical deregulatory maneuvers in Watters v. Wachovia. I'm sure Wachovia shareholders are now deeply grateful to the Administration and its friends at SCOTUS for sparing them the burdensome regs that might have prevented Wachovia's near collapse.

Back in mid-2004, the Center for Responsible Lending warned that OCC demonstrated "significant bias in its review of research conducted on the impact of anti-predatory lending laws", "ignor[ing] compelling research in favor of uncritical acceptance of flawed research that supported the OCC’s position." As Martin Eakes testified before Congress,

[T]he OCC’s expansive interpretation of the standard for federal preemption dramatically alter[ed] the . . . partnership between the federal government and the states in promoting a dual-banking system and in protecting the nation’s consumers. Rather than help to support the fight against predatory lending, the OCC has used strong rhetoric, biased research, and contorted legal analysis to undermine effective state efforts to combat predatory lending without cutting off access to credit.

I used to think that deregulatory fundamentalism "merely" undermined the legal profession and its larger purpose of promoting fairness and equity. The subprime meltdown shows that the consequences are even starker--that the fraudsters who've gotten a free pass from regulators for so long have rendered the entire financial system as fragile as the sham deals and entities they promoted.

Posted by Frank_Pasquale at 09:13 PM | Comments (2) | TrackBack

V.C. Strine's Path to Greatness

David Marcus has a tremendous article up about V.C. Leo Strine. Lots of tidbits I didn't know, including the influence of Third Circuit Judge Stapleton on Strine's views. Plus, there is this pretty fun quote from David Skeel:

"I have to imagine that what Strine learned from Stapleton was carefulness and judicial responsibility, and those are not the things you think of when you think of Leo," says David Skeel, himself a former Stapleton clerk and now a corporate law professor at Penn. "You think of his being flamboyant and not keeping things close to the vest. But it's also true that Leo is very careful and he doesn't make dumb mistakes."

Also, this on Chesapeake Corp. v. Shore:

"A Chesapeake v. Shore pours out of you like a clear mountain stream," Strine says. "I had been thinking a lot as I decided the cases that came up about these various standards of review and seeing some of the frictions and the overlap." Chesapeake raised precisely those questions, he continues. "The core parts of the standard of review flowed from my brain to my fingertips. When I went running, I would think about it, I would outline it in my head. You don't have cases like that every year, or every third year."

Like a mountain stream!

Posted by hoffman at 12:30 PM | Comments (2) | TrackBack

Bailout or Bust

I've gotten lots of great comments to this post, including an unusually large number of emails from liberal bloggers who think I've pulled a Colin Powell. As I read over their extremely angry letters, I started to have the sense that as many folks who opposed the bailout went to bed last night, they had a sudden, terrible, thought. Which went something like this:

"What if I don't know what I'm talking about, and we just deliberately hit an iceberg for the sake of short-term political gain?" And what if people, you know, held me to my words?

This morning, such doubts happily put aside as the stock market rose on bargain hunting and the still strong odds that we'll get some kind of bailout, the blogosphere has erupted in defensiveness. We're not celebrating Congressional fecklessness, we just hate bush/socialism!

As I've written back to these many commentators, this problem increasingly strikes me as one that facts won't help to resolve. Individuals' views of the risks of nonaction, and the costs of action, are bound up in their priors. So, it is with no expectation that I will convince any naysayer of the magnitude of the crisis that I simply call your attention to a little number that functions as the economy's DEFCON.

Go ahead, read the writing on the wall.

And now, you should feel free to return to your regularly scheduled diversions.

Posted by hoffman at 05:33 PM | Comments (3) | TrackBack

The Political Blogosphere Jumps the Shark & The Path Forward

As you probably know, the Great Bailout just went down in the House, failing for lack of support on both right and left. This, despite the (glaring) fact that companies need to float an enormous amount of paper tomorrow. And payroll day.

In any event, in the face of this shocking loss, Chris Bowers, at Open Left, comments:

Yes! (0.00 / 0)
It has been a long time since we won something like this. Great news. Hopefully, it will be pushed until after the election now.

Every day that passes when we don't hand this much power to Paulson is a good thing. Any bill that Bush would sign would suck. Let's do this after the election.

For now, yey!
by: Chris Bowers @ Mon Sep 29, 2008 at 12:58:12 PM CDT

This frame (Bush lied/people died/let the economy fail) has been all over the liberal blogs of late. I obviously think it is rank foolishness, by people who either don't understand how the economy works, or who hope that an economic contraction will help them advance their policy agenda. It suggests to me that political progressives aren't serious about governance, and aren't to be trusted with even the barest hint of power.

The conservative blogs have a slightly distinct, but equally destructive, position, born of misunderstanding their principles.

It's been a sobering education. I had thought that generally one ought not to be terribly concerned with federal politics, because most of the issues decided on the federal level are symbolic. That is, the differences between the parties are minor, and governance happens through the professional bureaucracy, which can be trusted to muck-things-up on a random, and thus not systemic, level. Now I understand that if the bloggers had their way, we'd see real change. In the direction of a socialist banana republic, or a crony capitalist autocracy. Shucks, until the last few weeks, I thought these folks were mostly kidding!

So here's the story. The credit markets are, for now, frozen or freezing. The Fed is going to try to move heaven and earth to restore confidence, but its ability to do so is in serious doubt, as our representatives seem to be willing to let the real economy tank so long as they survive their next election. I imagine there will be some hard arm-twisting in the House tonight, as members get calls from their local businesses saying something like the following:

Hey, Representative Tiahrt, it's Jeff Turner, President of Spirit Aero Systems. The largest employer in your district.

Tiarht: Er, hi!

Hypothetical Turner: So, I saw you just voted against the bailout.

Tiarht: Yes. "We've got to move away from this model of throwing money at the problem."

HT: Do you realize I've got to make payroll tomorrow?

Tiarht: "More effort should be made to bring in the private sector to take the burden off the federal government."

HT: What does that even mean? Insurance.

Tiarht: Er, yes.

HT: Is that some kind of sick joke?

Tiahrt: "I can't support a system that nobody understands," he said. "We think we know what they want to do, but it's pretty much 'trust me.'"

HT: Do you understand that not being able to borrow in the commercial paper markets, tomorrow, means that making payroll and expanding our business is going to be exceedingly difficult? [Note: I'm just using Spirit Aero as a convenient example, because it is a manufacturer with an large employee base, seeking to expand, in a no-voting-member's district. I haven't checked Spirit's finances. I'm sure they have a nice cushion.] Banks are hoarding cash because they don't trust one another. This is a tremendous collective action problem, just the kind that government exists to solve.

Tiahrt: I believe in free market principles. If we have to go into a Depression so the republican caucus can remain untainted, so be it.

HT: Is the free market a suicide pact?

Tiahrt: Yes.

HT: We'll see. Depression 2.0, if it comes, will likely lead to significant changes in the membership of the House.

Posted by hoffman at 02:40 PM | Comments (9) | TrackBack

Reading the Tea Leaves

I've been reading the Corner today. Based on this, this, and this, it looks like the Republican Study Committee is going to give up on its unworkable, ideologically blinkered, and foolish plan to deregulate the banking industry and give it a tax break. The RSC, and John McCain, are terrified of being blamed for shutting down the economy. Which could happen as early as Tuesday, as Jonathan Lipson points out in a comment to my earlier post.

My prediction: a bill with an insurance option (presumably priced so that no one will actually buy it) and, possibly, some of the nonsensical transparency solutions thrown into the mix. Passed by Sunday. And then? Full time employment for the administrative law bar.

I'll be in Toronto for the weekend at CLEA. If I turn out to be wrong about the bailout, maybe I'll just stay there for the winter. I've heard it's nice.

Posted by hoffman at 02:13 PM | Comments (0) | TrackBack

Throwing Executive Salaries to the Mob

Things are shifting so rapidly that it is dangerous to talk about consensus, but there does seem to be consensus that the executives of institutions that may benefit from the unloading of toxic securities need to take some sort of a hit. Why? It seems to me that there are a number of possible answers, some of them good some of them not.

In a conversation at the school bus stop the other morning, I heard the suggestion that the financial markets were in trouble because the executives were sucking so much of the value out of market with their huge salaries. "How can some people get paid hundreds of millions of dollars," one parent said, "and there still be money left to pay mortgages." I bit my tongue, but this sort of talk is just mathematically ignorant. The securitized debt market is $13 trillion and the credit derivatives market is $64 trillion. A couple of hundred million dollars is chump change. Still it is important to realize that there are a lot of people out there who think like this, and they vote.

A similar but slightly different argument is that the executives are morally culpable for the meltdown. It is not that their salaries are big enough to move markets on their own, but rather that they made a lot of stupid decisions that are costing other people a lot of money and they ought to be punished. The argument here, I take it, is frankly retributive. There has been wrong-doing and it ought to be punished. Alternatively, it may be based on some notion of unjust enrichment. The executives are profiting from their malfeasance and ought not to be allowed to do so.

This argument may or may not hold water, but as Christine Hurt and Jeff Lipshaw have pointed out the ultimate problem here is not one of fraud and wrongdoing, but rather of bubbles -- inflated asset prices and inflated expectations. There is a tendency for people to moralize what they do not understand. Assigning causation to evil doers is a mental shortcut that may make some sort of cognitive sense in face of complexity. It is not, however, always a good way of understanding the world. Of course, even if you don't think that the current crisis was created by fraud or other intentional wrong doing, one might still believe that irrational exhuberence deserves to be punished or is a sufficent basis for unjust enrichment.

Finally, one might object to executive salaries based on the argument that their current structure encouraged firms to focus on short term gains at the expense of the long term. I am sympathetic to this claim, although I am not sure what the regulatory response ought to be. There are good reasons for performance based salaries and golden parachutes. There is a tendency in some of the commentary about this mess to romanticize the financial and corporate system that existed before the deregulatory revolution that began in the late 1970s. Going back to a world of management that was blithely indifferent to the ultimate performance of their firms so long as the executive perks kept coming and held on to power with a death grip in the face of investors bent on change and better returns may not be the innocent and bucolic world that it is painted in some of the punditry. Still, I am open to the idea that we could improve the way that markets handle risks by shifting the incentive structures of managers. I just don't see much evidence that this is the kind of thing that the current proposals are aiming at.

The odd thing is that I think that the least compelling arguments for limiting executive compensation may actually provide the best reasons for doing so. As I've posted here before, I think that risks posed by bailouts includes not only the perverse economic incentives that they create but also the fraying of the social contract in support of market capitalism. Throwing executive salaries to the angry mob may not be such a bad idea for the long term health of the system. Indeed, given the news over the last week -- happy soul that I am -- I have a mind to take up a pitch fork myself.

Posted by oman at 10:35 AM | Comments (3) | TrackBack

John McCain's Unworkable Plan to Deregulate and Insure Our Way Out of the Crisis

Tonight, John McCain, by tacitly lending his support to the House Republican revolt against the Grand Compromise Bailout Plan, succeeded (?) in causing the negotiations to fail, at least for the time being. Expect a very black Friday on the market.

In the meantime, I'm trying to figure exactly what the McCain-backed counter-proposal means. The center piece is private-party funded insurance, with the premium price set by the government. Here's the key line in the proposal: "The Treasury Department can design a system to charge premiums to the holders of MBS to fully finance this insurance." It can? How? Let's explore three possibilities.

First, assume the government would just set the insurance premiums at some very high number. Let's even call it extortionate, since that's what the markets today would force you to pay to take on that kind of risk. Why would private companies agree to pay this rate? If the answer is that the companies will be forced to buy insurance, I don't see how that wouldn't immediately lead to those companies simply declaring bankruptcy. That, my friends, isn't the kind of liquidity solution we're looking for. Rather, it's what we've got today.

Second, assume that the government tries to price insurance at a low rate. Everyone pays the premiums, happily, because as I understand the proposal the government will be on the hook for failure, and we've now just done the bailout without any meaningful governance reforms.

Third, assume the government tries to price the insurance accurately, i.e., to reflect the likelihood that it will have to pay-out claims. Super. But figuring out the default risk is exactly the problem that the market has tried, and failed, to solve over the last year. Tens of thousands of the brightest, most motivated, brains on Wall Street have thrown themselves at this sucker. And the House Republican Study Committee thinks that the Federal Government's Treasury Department will be able to figure this out over the next few days.

Maybe I'm missing something, but the insurance plan seems, on its face, to be a joke, and not intended as a real solution to the liquidity crisis. There must be something else here.

Indeed, the McCain-backed-Republicans offered several governance reforms [with my comments in italics:]

(1) remove "regulatory and tax barriers that are currently blocking private capital formation"

I guess this means that the Republicans have decided that this problem is one of too much regulation, not too little. Repealing the CGT for two years is, of course, an old proposal of the republican study committee. In theory, it would result in up to $127B more in private hands annually (instead of government hands). But how can it possibly be that the RSC thinks that repealing the CGT have the same kind of liquidity effects as actually pumping money into the market. The repeal would be prospective, so only a small percentage of the $127B is at stake; and it isn't at all clear that investors would take the money and plow it back into stocks. I wouldn't. If I had extra cash, right now, I'd buy gold, like everyone else I know. Moreover, it would be less than the cost of the AIG bailout, which did nothing to halt market turmoil As for the idea that deregulating the financial institutions will unfreeze their lending behavior, I think I'd stand on Paulson's (reported) response: incredulity.

2. Increase transparency by requiring firms to disclose the MBS assets on their books, recent bids, and audits; prevent the government from buying high risk loans; require the SEC to audit corporate books and review the credit rating agencies, and "create a blue ribbon panel with representatives of Treasury, SEC, and the Fed to make recommendations to Congress for reforms of the financial sector by January 1, 2009."

Some of these solutions, like peering under the hood of the credit agencies, are good policy and ought to be enacted. Transparency too is a good thing. And blue-ribbon panels give reporters more substantive news to ignore, so I'm in favor of them too. But it's obviously true that none of the suggestions, in any way, would alleviate today's crisis. Transparency isn't the issue, rather it's that most of the MBS have no clear value (and perhaps no positive value) because (1) the housing market is in a meltdown; (2) the instruments are complex and leveraged; and (3) they are widely distributed. Transparency is a solution when the data are clear. When the water is muddy, glass bottom boats increase vulnerability without adding enjoyment to the trip.

I imagine that I'm missing something. But it seems like the House Republicans have put together a proposal that would almost certainly not fix the market crisis, and, would instead, deregulate the very firms that got us into this mess.

I know that I just recently ranted against political blogging. But John McCain's willingness to disrupt a very fragile political compromise on a bailout, and support for this hashed-up plan, really makes me concerned both for his judgment, and the future of the country. In my view, given that he has no expertise in this area, and his presence makes politicians think about the November, instead of this week, the right thing for him to do is to announce tomorrow morning that in the interests of the country, he will support any bill that garners the support of the majority of representatives in the House. He should then leave town on the first available plane.

[Update: Just to be fair, the online-left is equally foolish about this. Chris Bowers has a post up that assumes that we have forty days to debate this issue, as if it were a normal political problem, the crisis being manufactured by a self-dealing industry and a captive Congress. Lunacy.]

Posted by hoffman at 12:05 AM | Comments (8) | TrackBack

A Shoe Drops

This isn't terrific news:

Chinese regulators have told domestic banks to stop interbank lending to U.S. financial institutions to prevent possible losses during the financial crisis, the South China Morning Post reported on Thursday.

The Hong Kong newspaper cited unidentified industry sources as saying the instruction from the China Banking Regulatory Commission (CBRC) applied to interbank lending of all currencies to U.S. banks but not to banks from other countries.

Posted by hoffman at 11:11 AM | Comments (0) | TrackBack

The Draft Bailout Plan: Say Goodbye to Director Primacy

Via TPM comes the executive summary of the draft bailout plan circulating on the hill. Looks like Dodd's bill, though with language about executive compensation that provides a "perverse incentive" for "inappropriate or excessive risk taking". Additionally, participating companies have to permit extremely broad shareholder democracy! (This would be a pretty extraordinary change in current practice.) There also language about helping mortgagees that Frank & Kaimi ought to like.

Notably absent: any discussion of the cost of the program or its funding; a bailout of foreign firms; a pricing mechanism.

More later. Off to teach Corps, where I will, no doubt, speculate wildly about what this does to the future of Delaware's preeminence as a source of corporate law.

Posted by hoffman at 05:50 PM | Comments (0) | TrackBack

Chapter 11 as Metaphor: The Financial Systems Restructuring Act of 2008?

Last week, when all that was on the table was the mere collapse of a few investment banks and one large insurance holding company, I posted Jonathan Lipson's lucid analysis, identifying the "selective socialism" of A.I.G.'s bailout as a consequence of the Bankruptcy Amendments of 2005.

Now that we're frying bigger fish, I wondered what Lipson would say. His comments follow:

There are many options for a bailout. One that has received surprisingly little (if any) attention in Washington is reorganization under Chapter 11 of the United States Bankruptcy Code.
Strictly speaking, Chapter 11—which governs business reorganizations—would not apply in any meaningful way to many of the entities that are concerned here. Nor should it. But its general approach may, by analogy, be instructive.

Chapter 11 is a response to the collective action problem presented by a company’s general default. It is designed to enable parties to work out—restructure—legal and economic relationships with a mix of market incentives and government oversight. Some features of that system might, by analogy, help to avoid the growing stalemate in Washington while also creating mechanisms that actually resolve the underlying financial problems.

What, then, might a Financial Systems Restructuring Act of 2008 modeled on Chapter 11 do?

Stay

The Bankruptcy Code provides that the commencement of a case creates a stay of collection actions. This is vital, since it enables a troubled business to focus on correcting underlying problems rather than responding in ad hoc fashion to large numbers of collection suits.

Here, a stay might temporarily halt foreclosures on homes and enforcement of the various instruments currently in private hands that are apparently in default (or about to default). It could temporarily stay collection on credit default swaps. It would only be temporary, while a more fulsome plan is developed (see below).

Financing

Simply freezing the market, without more, would be the disaster Paulson legitimately seeks to avert. So, the government must inject capital and acquire some distressed assets to revive the capital markets.

Bankruptcy reorganization contemplates this through what is known as “debtor in possession financing,” where banks or other financial institutions make short term (usually) high interest loans to finance the process of a company’s reorganization.

Here, the Fed may lead a syndicate of lenders to provide short term financing to keep capital markets functioning, with the understanding that this financing would have to be repaid. It might be repaid in whole or in part by the Federal government, but that would depend on the development of a more fulsome plan (see below).

Today, of course, we do not know how much is really needed to stabilize markets in the short term. Paulson wants $700 Bn. But, like the claim that Iraq had weapons of mass destruction, I have seen no credible evidence supporting this number. Paulson and Bernanke admit that it may be too much or too little.

There is likely to be some smaller number that would stabilize the markets until, say, after the election. I don’t know what that is. But I would certainly hope that it was something far south of $700 Bn.

Market Testing—Treasury as Stalking Horse

The reason Paulson and Bernanke can’t tell us the right number is because there has been a market failure. No one, apparently, wants to purchase the toxic paper. If the market is what a willing buyer would pay a willing seller then, strictly speaking, the paper has a value of $0.

But in the long run, that seems unrealistic. I am sure that many CDOs were issued with nothing but smoke and mirrors behind them. They probably are worthless. But I am equally sure that many MBS are backed by real mortgages that really are worth something. We need to develop some mechanism for assessing the value of these securities, for many reasons.

Reorganization under Chapter 11 offers a helpful analogy. It contemplates fairly quick sales with auction mechanisms designed, at least in theory, to maximize asset values.

Here, rather than simply buying securities wholesale in the opaque and unaccountable way proposed by Paulson, perhaps the Treasury should be the statutory stalking horse in a series of controlled auctions, buying only where no one else will. I don’t know what formula should be used to set the initial price, but suspect that if this is done in some reasonably transparent way, it would produce better values and help to revive the market.

Reorganization Plan

There has to be some larger plan about how to address the underlying problems. In Chapter 11, this is called a plan of reorganization, and becomes the contract between the debtor and its stakeholders if enough of them support it.

A reorganization plan takes time to develop, but is essentially a set of rules that define how the affected parties will behave going forward. I am of the (admittedly under informed) view that much of the trouble here was driven by investment bankers’ and hedge fund managers’ fee incentives to issue and buy as much paper as possible, and the credit rating agencies’ incentives to provide unrealistic ratings of that paper because they were paid by the sellers, not the buyers. If these were the problems, a plan should include rules that address these problems going forward.

It should also contain a funding mechanism. Here, the initial funding might come from Treasury. But it seems possible to establish various mechanisms for recouping or minimizing some of the costs, whether through the auctions described above or in the form of fees paid by the largest beneficiaries of the bailout, or equity in those entities, or new debt issued by them, and so on. Some of these proposals are already on the table.

One of the problems with the Paulson proposal—which the Senate response does not really address—is how to value whatever it is the government gets in the bargain. Everyone now agrees that the government should get something--an “equity interest” or maybe debt of firms whose toxic paper the government acquires. But how much equity? At what valuation? With what rights?

These questions are usually at the heart of the negotiations over a Chapter 11 reorganization plan. We can’t really answer these questions now, however, because we don’t know enough about the underlying values.

I suspect part of what concerns Congress and the taxpaying public is that Paulson’s proposal simply sounded like more “planning by opportunity,” which is really no plan at all. Congress has legitimate concerns, many of which could be addressed in an intelligent plan. But that takes time. Using a stay, short term financing and controlled auctions may buy the time and gain the information we need to better understand the real problem and develop a more lasting and effective response to it.

Governance

A central feature of Paulson’s plan was that it made no real effort to change the governance of financial institutions. Executives would keep their jobs. The Treasury would acquire bad assets, not bad firms (although one could argue that enough bad assets make for a bad firm). Congress has responded with a much more rigorous oversight program, which might help.

Part of the logic of Chapter 11—and what distinguishes it from many other bankruptcy systems—is that management gets to remain in possession and control of the troubled company. But, there is considerably more oversight, both by the government (in the form of a bankruptcy judge and the office of the United States Trustee) and stakeholders (in the form of committees of creditors and equity holders) than in the marketplace generally.

Here, governance would remain with companies that participate in the program. But, picking up on the Senate bill, oversight would be provided by an Emergency Oversight Board, or similar entity. It would review not simply the decisions of the Treasury Secretary but consider how those decisions affect all stakeholders, including taxpayers and financial institutions. It might function like a combination of a bankruptcy judge and creditors’ committee. And, its decisions, like the decisions of the Treasury Secretary under the Senate bill, would be subject to some administrative and judicial review.

Recoveries

There’s a great deal of discussion about how much Wall Street executives should be “punished” for this. That’s an understandable sentiment.

But this sort of talk is not likely to get executives excited about any plan. Among other problems, merely capping future compensation simply gives executives an incentive to do nothing. If they are terminated by a board that wants them to compromise and work with Treasury, they may well sue on their employment agreements and hope for the best.

I am frankly less concerned about executive compensation going forward than I am about recovering from those who caused the problems. It seems to me unlikely that capping John Thain’s future salary (were Merrill independent and seeking a bailout) is likely to do much good. But getting back the $57 million Stan O’Neill took away might be a good (if small) start.

How would that be possible? Bankruptcy incorporates a number of traditional legal mechanisms for avoiding transfers of property, or remedying other conduct, that might have harmed a debtor.

Here, this would mean that someone like the special inspector general (SIG) contemplated under the Senate proposal might be empowered to investigate the banks and hedge funds that played a major role in this crisis and to sue under recognized (albeit perhaps strengthened) principles of fraudulent conveyance, breach of fiduciary duty, professional negligence, etc, with the recoveries going to the Treasury, subject to appropriate oversight.

The SIG would have to be given explicit standing to sue on behalf of these entities. This won’t sit well with everyone, but those who have little to fear should have little to lose.

Questions

Using reorganization as a metaphor would obviously leave many questions. After all, the whole point of Paulson’s initial proposal was to avoid the equivalent of bankruptcy—taking banks over.

The political standoff at this point seems to reflect competing ideologies. The administration says “trust us” and the market will heal itself. The Democrats seem to want something much closer to the Resolution Trust Corporation which really did take over failed banks. Republicans don’t seem to know what they want—other than to be (re-)elected.

None of this seems promising.

Restructuring as contemplated by Chapter 11 of the Bankruptcy Code can be seen as a third way, a hybrid, that might give us time and information that would permit cooler heads to really figure out what’s going on without an unchecked giveaway or total system meltdown.

Posted by hoffman at 05:57 PM | Comments (2) | TrackBack

David Simon on the Tensions of Capitalism and Shareholder Wealth Maximization

Via Ross Douthat, I just came across this interesting speech by David Simon, creator of the Wire. Worth listening to.